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Rate caps can curtail ARM payment shocks

August 06, 2007

Virtually all adjustable-rate mortgages, including the traditional, hybrid, option-payment and interest-only varieties, feature caps that limit how much the interest rate--and consequently your monthly mortgage payment--can be increased when your interest rate is adjusted. These rate caps are important because they protect you from unlimited higher payments, no matter how high or how quickly market interest rates rise.

What are initial, periodic and lifetime caps?
The most common ARM caps are the “initial cap,” “periodic cap” and “lifetime cap.” The initial cap limits how much the interest rate can be increased the first time it is adjusted. The periodic cap limits how much the interest rate can be increased each subsequent time that it is adjusted after the initial adjustment. The lifetime cap sets a maximum amount by which the interest rate can be increased as long as you keep the loan.

Not all ARMs have an initial cap that's different than the periodic cap. If your loan has an initial cap, it is likely to be higher than the periodic cap. If there is no initial cap, the periodic cap applies to the first adjustment as well as to any subsequent adjustments.

How adjustable-rate caps work
The adjustment period is determined by the type of ARM that you have. For example, a “5/1” ARM means the first adjustment will occur five years after the loan was originated and the subsequent adjustments will occur annually after that.

When the loan payment is adjusted, the lender adds a set amount called the “margin” to a specified market rate called the “index” to figure out the new interest rate on your loan. The index is often the LIBOR (London Inter-Bank Offer Rate) or the one-year U.S. Treasury interest rate. If the index plus the margin results in a higher interest rate than either the current rate on your loan plus the initial or periodic cap, as applicable, or the introductory rate plus the lifetime cap, your rate will be limited to the capped (i.e., lower) amount.

Suppose you had a 5/1 ARM with an introductory interest rate of 3 percent, a margin of 2.5 percent and an initial cap of 4 percent. Suppose further that five years after you obtained this loan, the index stood at 5 percent. At your first adjustment, your new, fully indexed rate would be 7.5 percent:
Index: 5 percent
Margin: 2.5 percent
Fully indexed rate: 7.5 percent

But the periodic cap would limit the interest rate at your adjustment to 7 percent:
Introductory rate: 3 percent
Periodic cap: 4 percent
New interest rate: 7 percent

As a result, the adjusted interest rate on your ARM after five years would be 7 percent (the capped rate), not 7.5 percent (the fully indexed rate).

The lifetime cap is important because it determines the highest interest rate possible on your loan, and consequently, the highest monthly payment that could ever be applied to your loan. For example, if your ARM had an introductory rate of 3 percent and a lifetime cap of 6 percent, the rate could never be higher than 9 percent, even if the margin was 2 percent and the index increased to, say, 7.25 percent. The margin plus the index would equal 9.25 percent, but the lifetime cap would limit the interest rate on your loan to 9 percent.

Loan documents disclose caps
The caps on your ARM, along with the adjustment periods, margin and index, should be disclosed in the loan documents that you signed when you obtained your mortgage. If those documents aren't handy or you can't find the information you need, call the telephone number on your monthly mortgage statement and ask the lender or loan servicing company to assist you. If you obtained your loan through a mortgage broker, he or she also should be able to explain the caps and other rules of your ARM to you.

Example: Rates caps on a 5/1 LIBOR ARM
Loan term 30 years
First adjustment period 5 years
Subsequent adjustment periods 1 year
Index 1-year LIBOR
Margin 2.25%
Initial rate cap 5%
Annual rate cap 2%
Lifetime rate cap 5%

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